Network Industries

Network industries differ from regular, competitive markets in that inequality exists naturally in the market. Economides (2004), states that in the case of a network industry with network externalities, the introduction of competition does not significantly alter the structure of the market. The equilibrium of the market is not a competitive one, and prevents perfect competition from developing. The conditions of free entry imposed on network industries do not alter what Economides calls the "incompatibility equilibrium" or the extreme inequality in market share. This equilibrium occurs naturally in network industries, and is not sustained through anti-competitive behaviour, so competition laws will not amend this flaw in the market. This market structure results in a natural equilibrium called "winner takes most", in which there will always be a dominant firm, preventing a perfectly competitive equilibrium. Economides (2004) warns against the imposition of a competitive market structure, suggesting that the effects of doing so would be detrimental rather than beneficial to the market, and recommends that competition law should be applied, not using a perfectly competitive market structure as its basis, but judging the industry on its individual features.

Whilst moving towards a policy of full deregulation within a state owned monopoly, it is common to have a transitional stage when the industry is partially deregulated (Viscusi et al. 2005), as has been seen in the UK public utilities. It is preferable to have a gradual, staged move towards a fully liberalised market to allow firms time to adapt. In the UK, this course of action was taken by industry regulators within the traditional, state-owned network industries, with the allowance of free entry to the markets, yet price controls were maintained. It is common for the regulator to control the prices of the established firm whilst allowing new entrants to set their own prices. This is to prevent predatory pricing from the incumbent operator driving competitors to insolvency. However, this type of regulation is asymmetric, and has been criticised for allowing unfair competition. Asymmetric regulation can result in 'cream skimming' by competitors who are able to gain much of the profitable custom from the incumbent due to the freedom they have to set their own prices.

Network effects or externalities describe the value added to a unit of the good when the number of goods sold increases (Economides 1996). For instance, there is very little value in being the sole user of a telecommunications network, and so the value to the buyer of a telephone would be very low were this the case. The value of having a telephone and connectivity is heightened by the number of your peers who are also connected to the network. Therefore, contrary to normal goods, the willingness to pay for the last unit rises with the number of units sold (Economides 2004). This increase of the number of users also builds up economies of scale, scope and density within the network, which means that the unit cost will drop, theoretically decreasing the price to the consumer.

Competition in network industries:

Network industries have, traditionally, been run as regulated monopolies rather than competitive markets. There are several reasons for this. Primarily, it was the intention of the government to ensure that all consumers were able to access basic utilities and services. In a competitive market, operators would compete for the profitable routes and custom, whilst the parts of the network where no profit was available would be neglected, or offered extortionate prices to receive the service. Therefore, the state owned monopoly of utilities is a result of market failure. Across many network industries, there is an obligation for the incumbent operator to supply to the entire network at standard, reasonable price level. This is known as the Universal Service Obligation (USO). It is necessary that the national network of industries such as telecommunications and post are non-excludable on the basis of location and price. However, the costs of supplying these services to each individual consumer differ greatly. For instance, it costs the operator more to supply to consumers living in rural area, as the population density is not as high as in rural areas, and more resources are used in the supply to these areas. In the UK public utilities sector, this cost difference has led to the practice of cross-subsidisation, which means that profits generated from more profitable products are used to subsidise those goods or services which do not generate much, if any profit for the firm. The result is that the consumers in rural areas pay a below cost price for the services they receive, whilst those in urban areas pay a price which is above the cost of the service they receive. It is these urban users that provide the operator with the large profit margins, which are used to cross-subsidise the loss-making rural operations. It is these urban markets where competition is more prevalent, as these areas provide the largest profits. The market would fail because no company would wish to supply to the consumers that they make a loss, and without obligation these consumers would have to go without the commodity.

These same conditions apply for the other network industries offering a standardised product such as water or gas. Thus, in each of these industries, competition occurs through access agreements, whereby the incumbent operator allows access to their existing network to allow competition to develop in the market. The competitors are charged a flat rate fee by the former monopolist, and in turn are able to provide the same services to their customers as the incumbent. This allows the users of the network to maintain their positive network externalities, whilst competition will in theory lead to a reduction in prices.

• Telecommunications:

Telecommunications in the UK were, until 1980, run by the Post Office. In 1980, the department of the Post Office charged with running the telecommunications industry was renamed British Telecom (BT), and was run as a state-owned monopoly until 1982, when a license was awarded to Mercury, creating an oligopoly. BT was privatised in 1984, when the UK government sold just over 50% of its shares in the company. In 1990, the oligopoly ended when the market was opened to competition. This competition was introduced with a similar access regime that was deployed within the gas industry, and this access is still how competition is formed today. In 2002, Frontier Economics published a report on behalf of Postcomm, examining the effects that privatisation and liberalisation have had upon former state monopolies in the UK. The resultant findings were that productivity and efficiency substantially increased within BT upon the end of the oligopoly period in 1990, with the average number of employees falling by nearly 100,000 in the first five years of competition, whilst employee levels were stable prior to the introduction of the competitive environment. This shows the reactive measures taken by an incumbent to become more efficient when the threat of competition becomes real. The report also notes that the privatisation of BT has led to an average price reduction of 5.1% per annum between 1984 and 1999, and an overall productivity increase of 25.5% to 1999, or 4.8% per annum average.

• Gas:

Since its inception in 1972, British Gas had been a stated owned monopoly. In 1982, competitors were granted access to British Gas' network of pipelines and infrastructure, in order to be able offer gas to final customers around the country. This is similar to the competitive environment introduced through local loop unbundling agreements in the telecommunications sector. Simultaneously, competition was introduced in the purchase of gas from suppliers, ending British Gas' monopsony in the market. In 1986, the gas market was segregated into two categories; the tariff market, which consisted of low volume gas users, such as households, and the contract market, primarily businesses and higher volume users. British Gas retained a monopoly in the tariff market, which had its prices regulated, whilst there was competition allowed in the contract market. Also in 1986, British Gas was privatised as a vertically integrated monopoly. This differed from the liberalisation process seen in the electricity industry, where the incumbent was separated into a national infrastructure, and several regional suppliers (Armstrong & Sappington 2006). Several regulatory reforms were necessary to prevent the incumbent from conducting discriminatory pricing by charging higher prices to industrial gas users with no alternative sources of energy available to them, as well as the prices they charged competitors for access to the pipeline network. Other regulations introduced included the limiting of the share of gas allowed to be bought, and subsequently, supplied by British Gas, forcing entry to the market. By 1998, all consumers were able to access a competitive market, and pricing control determinations were removed in 2002. This highlights a gradual liberalisation of the natural gas market in the UK, and this general framework was followed across other former state monopolies, albeit with industry-specific alterations.

• Electricity:

The UK electricity industry is separated into four different aspects. There is the generation, transmission, distribution and retailing of power before electricity reaches reach the British consumer. Until the 1989 Electricity Act, the industry represented a natural monopoly in each region and sector of the industry. The Central Electricity Generation Board (CEGB) owned all of the generation and transmission of electricity for England and Wales, selling power to Boards which each represented an area, which were subsequently responsible for the distribution and selling of the power to the consumer (Newbery 2004). In Scotland, there were two boards, one covering the north and the other the south, each of which had franchises covering all aspects of generating electricity.

In 1989, the ECGB was separated into four companies; two for generating electricity, one which became the modern day National Grid plc, and one for nuclear power. Apart from the nuclear aspect, the companies were formed as public limited companies (plcs). The regional area boards were also made into plcs, and the National Grid was placed into the joint ownership of these companies, which were floated on the stock exchange in 1990. The process which has allowed competition to be introduced into the supply sector has been similar to that seen within the gas industry; with users with demand above 1MW able to choose suppliers first, and gradually the limit was lowered, to 100kW, and in 1999 the entire market was opened to competition, as the regional plcs' franchises ended. Competition in electricity generation was also able to occur due to the creation of the Electricity Pool, a wholesale electricity market auction through which all generators has to sell their power to suppliers (Newbery 2004).

The aftermath of the liberalisation of the UK electricity market in 1990, and the formation of four companies in a competitive structure, there were large increases in productivity. Newbery and Pollitt (1997) estimate that labour productivity increases were around 100%. Both National Power and PowerGen doubled their megawatts per employee capacity between 1990 and 1998 (Postcomm 2002). It is suggested that these increases were largely due to the reductions in the labour forces of the companies, as they became more streamlined. Newbery and Pollitt (1997) estimated that after five years of privatisation in the electricity sector, costs were 6% lower than they were prior to the restructuring of the CEGB, with costs per unit significantly lower. DTI Energy Prices data shows that the price per kWh for the average consumption of 3300kWh per annum in London was 7pence in 2004, compared with over 11.5pence in 1991.

Conclusion:

The three examples of the liberalisation of state monopolies highlighted show that despite having common characteristics, each industry is different. Each method of liberalisation shown has features which are unique to the individual markets, yet there is a common basis in the approach. For instance, the introduction of competition in each industry is enabled through allowing suppliers access to the already established network. There is a consensus that having two parallel, competitive networks would be inefficient, in terms of cost both for the operators and the consumers. Economies of scale would drop such that unit cost would rise and the cost to the consumer would have to rise, reducing consumer surplus. The form of regulation in each industry is that of issuing licenses to operate for all market segments, a system which Newbery (2004) praises in comparison to the regulatory systems in the European and North American electricity markets. Terms of these licenses include the requirement for the license holder to provide the regulator with the information that it needs to accurately and knowledgeably monitor the industry. This should allow the regulator to foresee any abuses of regulation and act swiftly to prevent them. All three industry regulators have retained some form of price controls which limit the profit margins of operators of the monopoly networks (Ofcom, Ofgen). Conversely, the methods used in the deregulation of each industry have differed, especially in the case of the electricity market, which created regional monopolies competing for electricity supplies rather than customers. This highlights the importance of using precedents and adapting them to suit the industry in hand.

Chapter 3 - Postal Services vs Network Industries:

The postal industry across Europe is changing in shape. The letters markets are in structural decline across the continent. Other, newer forms of communication have become more prevalent in recent years due to the technological advances of late. A study by The International Post Corporation points out that the postal industry is becoming less of a two-way communication channel, and more of a one-way method of distribution. This opinion is corroborated by Crew and Kleindorfer (2008) who suggest that the plans to reform the market in Europe stem from the declining mail volumes, which are primarily a result of technological advances in other forms of communication which have been assisted by the previous liberalisation of these markets. Specifically, the vast and rapid increases in the use of e-mail and text messaging have led to a cycle of negative growth in letters sent in the United Kingdom and in Europe in recent years. Institutions such as banks and businesses are able to send statements, invoices and payments, through more time and cost efficient electronic means of communication. This has resulted in a reduction in the amount of 'transactional mail' sent in the UK. 'Social Mail', such as correspondence letters between consumers is also on the wane. The emergence of text messages and emails has reduced the requirement for letters, which are a lot slower. Only the use of greetings cards has continued strongly, with most consumers still preferring to send and receive greetings in paper rather than electronic form (Hooper et al 2008), as people still attach value to the personal touch of sending a letter. These factors have led to a continuous year-on-year decline in the volume of mail being sent in the UK. Hooper et al (2008) suggest that Royal Mail lost £500million in operating profit to other forms of communication in 2007-8.

On the other hand, the growth of technology over the past ten years, primarily the internet, has led to a large upsurge in the number of parcels and packets being ordered and delivered by Royal Mail and other courier companies. The Hooper Report (2008) places the value of online retail at £42billion annually in 2007, 10% of all retail sales within the UK, with this figure set to rise to £78billion in 2010, 20% of all retail sales in. This will be of benefit to Royal Mail; however, the estimates show that the expected rise in packet volume will not be enough to replace the lost revenue from the declining letters market (Hooper et al. 2008). Effectively demand is changing, and the market needs to adapt to meet this new demand.

• Natural Monopoly:

Viscusi et al. (2005) describes a natural monopoly as an industry where the cost is minimised if the production of a good or service is provided by one firm. This criteria leads to the cost-function of the industry is sub-additive. Sub-additivity is generally obtained if both economies of scale and economies of scope exist. Cazals et al. (1997) finds evidence of sub-additivity in the delivery sector of the postal industry. The study found that it would be 5.2% less costly for one firm to provide the market than if two firms were to equally share the delivery of the existing volume of mail.

The sub-additive cost function that is necessary in defining a natural monopoly. Up until point Q', production is showing economies of scale, with a decreasing average cost. This shows that it is cheaper for one firm to supply the market until point Q', and that cost is sub-additive for that range of outputs. However, after point Q' is reached, average costs begin to rise.

NERA (2004) suggests that finding economies of scale and scope within a specific part of the industry; i.e. the delivery or sorting capacities, is "sufficient" to determining that a natural monopoly exists. In this regard, Bradley and Colvin (1994) find that a natural monopoly exists within the delivery segment of the postal industry, due to the presence of economies of scale and scope. However, NERA (2004) mentions that the authors accept the conditions are easy to satisfy, and Wada et al. (1997) find "mixed evidence" on the sub-additivity of the cost function in parcels and letters delivery.

• Economies of Scale:

On the issue of whether or not there are economies of scale within delivery, Cazals et al (1997) and Cazals, Florens, Roy (2001b) found returns to scale ranging from 1.10 to 1.68 for La Poste, the incumbent operator in the French postal market. This means that based on a 10% increase in volume, costs would increase by less than 10%, with these studies estimating that costs would increase by 9% and 5.1% respectively. In a study of the United States Postal System (USPS) conducted by Christensen et al. (1993), there was found to be returns to scale of 1.26, meaning a 10% increase in inputs would provide the capability for a 12.6% in mail volume delivered. Further studies by Bernard et al (2002) (La Poste), Bradley and Colvin (1994) and Cohen and Chu (1997) (both USPS) discovered decreasing unit costs with an increase in volume in the delivery sector of the companies.

The decreasing average cost involved in postal delivery even at a market share of 100%, and that economies of scale are in existence. Thus, the graph for Royal Mail never reaches the Q' point highlighted in Figure 1, and the cost function remains sub-additive. This shows that it is cheaper for one firm to supply the market than multiple firms, providing one of the criteria showing the existence of a natural monopoly in the delivery segment of the postal industry. Thus, it can be verified that significant economies of scale exist in the delivery of mail, regardless of the conditions and parameters set and used by the econometricians conducting the studies. The parameters set do, however, influence the results in terms of the extent of the economies of scale, as can be seen from the variation in the economies of scale reported for La Poste by different reports.

Within the entire postal operation, rather than solely the delivery aspect, the economies of scale reported are lower. Norsworthy et al. (1991) estimates a value for returns to scale of 1.10 in USPS, whilst Wada et al. (1997) returns a value of between 1.03 and 1.06 for Japan. The reason for the lower values is the addition to the calculations of upstream activities, such as transportation and sorting which do not normally contain economies of scale. However, Rogerson and Takis (1993) found that economies of scale vary in transportation, depending on the mode of transport, and whether the journey is short-haul or long-haul. For instance, long distance transportation by road exhibits returns to scale of 1.11, compared with a figure of 1.01 - 1.05 for long-haul air transportation. Furthermore the existence of economies of scale was evident in short-haul transportation, with a figure of 1.52. It is important that this study was conducted on the USPS, which covers an area multiple times larger than the area served by Royal Mail in the UK. In that respect, the majority of journeys undertaken in the UK by Royal Mail will correspond as 'short-haul transportation', thus showing economies of scale will be prevalent in Royal Mail's transportation system. There was mixed, inconclusive evidence by the aforementioned authors as to the existence of economies of scale in mail processing operations. The overriding belief is that any economies of scale involved in sorting are insignificant, and do not act as a deterrent to new entrants, as is shown by the number of companies competing with Royal Mail in upstream activities rather than delivery in the UK.

• Economies of Scope:

The Bradley and Colvin (1994) paper also investigated the existence of economies of scope within the postal industry. The term 'economies of scope' refers to what happens to unit costs when one firm produces two or more outputs through the same system or network. In the postal industry, this refers to the co-existence of first class, second class, bulk mail, and parcels within the same Royal Mail network. The results of the study were that economies of scope exist amongst all types of mail, but only to a very small extent for parcels. This means it is cost efficient for all mail with the same destination, to be processed, transported and delivered together where possible, regardless of type (Rogerson and Takis 1993). This may not always be possible due to high volumes of mail, and the requirement for 1st class mail to be delivered with one day. The exception for parcels could be that due to their size, it may be necessary for a separate delivery to take place. This also occurs for Special Delivery items in the UK, which are processed completely separately from one end of the delivery chain to the other. This could result in multiple deliveries occurring to the one address on any particular day, reducing efficiency, and causing diseconomies of scope.

Thus, it would appear that even despite econometric studies, the question of the existence of a natural monopoly within the postal industry cannot be categorically answered. It would appear that each report arrives at similar conclusions on the matter. The statistical evidence points to an agreement with the IPC report, in that, strictly speaking, a natural monopoly does not exist in the postal industry. On the other hand, the market contains many of the mannerisms of a natural monopoly, which do act as a barrier to entry for competitors, which corresponds with the opinions expressed by competitors in the survey within the Hooper Report.

• Network Industry:

The major difference between the postal industry and the traditional network industries, as noted by the IPC (2007) is that the postal industry does not incur the vast sunk costs required to establish an infrastructure. For instance, Royal Mail's network is one which is made up of a variety of components. The company uses public roads, railways and airways to transport its mail, and so much of its costs are in vehicles. There is no large sunk investment required by Royal Mail to use these public facilities, in the way that British Gas required an expensive national network of pipelines to supply its gas. Also, the costs in the business are predominantly people based. Royal Mail's financial accounts for the year ended March 29th 2009 show that 65% of its costs are people costs, including wages and pension costs. Another 17% of costs are in the 'distribution and conveyance' part of the business, consisting predominantly of transport costs. Some of these transport costs will be sunk cost investments in new vehicles, whilst some will be fixed running costs in the form of fuel. Thus, more than 65% of Royal Mail's annual costs are categorised as fixed costs. This shows that the level of sunk costs involved in the business is relatively low in comparison to the traditional network industries, and this is the criteria used by the International Post Corporation (2007) to reject the suggestion that the postal industry is a network industry in the classical sense.

Overview of Industry:

The letters business of Royal Mail is divided into five operational stages: collection, sorting into regions, transportation, sorting in delivery offices, and delivery. Mail is collected at least once daily from each of the 115,000 pillar boxes, 12,000 post offices and 87,000 business addresses (Hooper Report 2008). The mail collected is then transported to one of 69 regional mail centres, where it will be sorted into regions; with local mail being sorted and sent to local delivery offices (DO) for delivery, while national mail is taken to one of nine national distribution centres. From here, the mail is transported by air, rail and road to the appropriate mail centre, where it is sorted and transported to each of the 2249 delivery offices. At the delivery office, mail is sorted into walks or duties, and sequenced into order before delivery commences.

Competitors of Royal Mail are able to compete in the collection, sorting, transportation and delivery of mail. The industry regulator, Postcomm, has granted licenses to 21 companies, in addition to Royal Mail, allowing them to operate in all market sectors. Therefore full competition regulation has been implemented. However, as of January 2010, the new competitors have opted not to compete with Royal Mail in all market segments, choosing instead to focus their operations on the collection of mail from businesses and sorting, before handing the mail over to Royal Mail at the inbound mail centre stage of the process. From this point, Royal Mail is to deliver the mail across what is known as the "final mile" to the customer. This arrangement is called Downstream Access (DSA), with Royal Mail charging a fee per item to its competitors for delivery of their mail. This fee is arranged through agreement with Royal Mail and each individual operator wishing access to the network. If agreement is not met between the two operators, then Postcomm, acting as arbitrator, will set the access price. One important factor is that Royal Mail should be able to break even on the access activities it undertakes on behalf of other operators.

The DSA agreement is similar in type to what occurs within the classical network industries in the UK. Under the Local Loop Unbundling (LLU) agreement in telecommunications, competitors of British Telecom must pay a line rental fee to the incumbent network operator. Under the agreement, for a fee, BT must allow their competitors the use of the physical network to provide telecommunications services to their customers. This is the way in which competition was implemented in the telecommunications industry in the 1990s, and similarly it is the method of competition that has proved most popular since the postal industry was opened up to competitors on January 1st 2006. Bulk mailers are also allowed access to the Royal Mail network under a license called Customer Downstream Access (CDSA). This allows the largest mailers sort their mail internally, and avoid paying Royal Mail for collection and sortation, instead putting the mail into the system at the inbound mail centre stage of the process, similar to DSA.

Competition in the Postal Industry:

The competition which has developed within the UK postal industry has almost entirely been through Downstream Access. There has been very little competition in the "final mile" delivery part of the market. The justification of the access agreement was to allow alternative operators to build up economies of scale in the upstream part of the business (collection and sorting) that would therefore enable them to establish a delivery network of their own. However, whilst the uptake in the DSA agreements has been rising, with almost 40% of all items delivered by Royal Mail coming from DSA items, as of yet no operator has established its own delivery network. In reality, since the access agreement has been in place, end-to-end competition has decreased. It was suggested by Hooper et al. that the high uptake in the access agreements has dissuaded many operators from introducing their end-to-end networks, in the realisation that the upstream side of the business is less costly than the downstream delivery side. The delivery, or downstream part of the mail market, is very labour intensive, and is therefore very costly. These costs are generally fixed, as they are necessary for the provision of service to consumers. Royal Mail claims that the "final mile" delivery represents 44% of the entire costs of the business. In the year ended 5th April 2009, Royal Mail made a loss of £67million on DSA items, despite volumes increasing to 5.3billion items (Royal Mail 2009). It has been suggested by many in the survey incorporated in The Hooper Report that the current access regime could act as a barrier to end-to-end competition, because the margins involved in the delivery side of the business are so low that it is not worthwhile entering the downstream section of the market. However, the majority felt that the prospect of full competition has increased due to the establishment of the access regime because alternative operators have been able to build-up relationships with customers, as well as mail volumes in collection that develop economies of scale. It may be that end-to-end competition will develop in the future, once economies of scale have been developed, or it may not. However, in a recent episode of Panorama, TNT UK's chief executive announced plans to one-day soon begin their own delivery network, and have orange postmen and women on the streets of Britain. Whether or not this becomes viable in a financial or efficiency sense remains to be seen.

• USO:

The Universal Service Obligation (USO) is a law which insists that Royal Mail delivers daily to each of the UK's 28 million addresses. This agreement is in place to ensure that all consumers of the service receive the same services and products at the same cost. Akin to the telecommunications industry, it is more costly for the Royal Mail to deliver in rural areas than in urban areas, due to transportation costs. However, it would be discriminatory for someone to be financially penalised due to where they live. This means that people sending letters or parcels within urban areas, say from one London address to another, are effectively subsidising the letters sent in rural areas, for example from Land's End to the Outer Hebrides. Therefore, those sending letters within London are being charged more than the marginal cost of delivering that letter, whilst those in rural areas are charged less than the costs of delivery. The Hooper Report, published in December 2008 states that the USO is beneficial for society and the economy as it allows access to means of communication, enables trade, and is non-discriminatory towards those who are not regular users of the network and those on lower incomes. The Royal Mail has made a loss in excess of £100million in each of the last two financial years on products covered by the USO (Royal Mail Regulatory Financial Statements 2008-9).

Royal Mail's competitors are not subject to the provision of the USO, and are able to pick and choose where they wish to collect and deliver to and from. As they are profit maximising companies, there is no incentive for them to compete with Royal Mail on its loss-making routes, and they are free to cherry-pick the more profitable routes within the urban areas, where they can undercut the incumbent's subsidising price. Due to the one price for all rule determined by the USO, for a certain amount of mail, Royal Mail has to offer the same price to one company as it does for all other business customers for the uplift and processing of a certain amount of mail. On the other hand, competitors who are not subjected to the USO can treat business customers on an individual basis, allowing them to negotiate a suitable price which can be altered for another customer, even if the specifics of the arrangement are identical. This enables the competitors to undercut Royal Mail's prices and take a lot of profitable business from the incumbent operator. These arrangements were previously used to cover the cost of the USO. The Royal Mail needs the profitable, urban business to business mail to subsidise the losses made on the USO. If the business is unable to compete on price with its competitors then, put simply, it will lose business.

If the company has to spread its costs continually while its revenue falls then there will be less revenue available to subsidise the USO. This will lead to a necessity for Royal Mail to either operate at a loss, or increase its prices to cover the costs of running the USO. If Royal Mail is to be run as a profit making entity, then it cannot function with continual losses, and therefore the only option is to raise prices. If this occurs, assuming they are indifferent towards mail carriers, senders of bulk mail will refuse to pay higher prices if they can obtain a lower cost with a competitor, and so the revenue of Royal Mail will fall further. This will result in a cyclical decline in revenues and increase in prices, which can only end when Royal Mail's prices are sufficiently high that the USO is no longer running at a deficit, and requires no subsidy. However, by then, prices may be so high that businesses do not use Royal Mail to collect their mail. Also, as Royal Mail prices continue to rise, the competitors will be able to increase their prices and still maintain their level of business so long as they are less expensive than Royal Mail and the other operators. This will represent an increase in the level of inefficiency in the market.

Regulation in the Postal Industry:

Within an industry where competition is being introduced, there are two broad types of regulation that can be applied to prevent anti-competitive behaviour and uphold levels of service; ex ante and ex post regulation. Each has its' benefits and drawbacks, and there are conditions under which each is more suitable than the other. Ex ante regulation is a preventative measure which is established before any anti-competitive behaviour occurs, whilst ex post regulation consists of reactionary competition laws which are applied after anti-competitive behaviour has taken place. These powers consist of imposing fines or sanctions on Royal Mail should the company be deemed guilty of anti-competitive behaviour. Ex post regulation provides incentives for companies not to engage in an anti-competitive manner, whilst ex ante regulation prevents such conduct from occurring. Each type of regulation has its implications for the postal market. Ex ante regulation is more restrictive, particularly on the actions of Royal Mail, whilst offering more security to competitors and consumers that Royal Mail will not employ anti-competitive behaviour. On the other hand, ex post regulation provides more trust in actions of the incumbent operator, giving Royal Mail more freedom, but offers less protection and assurance for competitors and customers, as it is a reactionary measure. Enforcing ex post regulation, and punishing breaches of competition law can be a time consuming process requiring investigations, by which time the afflicted competitor could have been forced out of business by the incumbent's continued anti-competitive behaviour. However, under the current regulatory framework, Postcomm has no power to enforce competition law, thus preventing any use of ex post regulation within the postal market, and limiting the industry to the aforementioned ex ante regulation measures. This differs from the other communications industries, which are regulated by a single regulator, Ofcom, which has the power to impose competition laws on companies within its control, allowing a combination of ex post and ex ante regulation to develop. However, Ofgem, the energy regulator for the gas and electricity industries, has no power to impose ex post regulation, although the regulator itself wishes to be granted these powers (Consumer Focus 2009).

The current way in which the competition within the postal market is regulated has been criticised for the allowance of asymmetric competition. There have been accusations from Royal Mail's competitors that the incumbent operator's exemption from paying VAT is a barrier to end-to-end competition. However, this is a ruling from the European Parliament covering all state-owned postal operators in the European Union, and can only be revoked by the UK or European Governments. This issue is therefore out with the control of the regulator. A court ruling from the European Court of Justice in April 2009, upheld the VAT exemption due to Royal Mail's deliverance of the USO. This has two main impacts for Royal Mail, and its competitors. Firstly, and more evidently, it provides them with a comparative advantage over competitors, enabling them to offer customers better prices than they would otherwise. On the other hand, it also means that the Royal Mail, unlike its competitors, is unable to reclaim the VAT that it pays on goods and services, such as fuel and sorting machinery. This adds to the business' costs. Hooper et al. note that Royal Mail's VAT exemption has a limited effect on much of the market, due to the ability of most businesses to reclaim VAT charged to them by any competitor for services tendered. However, for those who do not have the ability to reclaim VAT, i.e. charities and financial institutions; Royal Mail's VAT exemption gives the incumbent operator an advantage over its rivals.

Royal Mail has also submitted several complaints to the regulator regarding asymmetric competition. The main issue is that of the "cream skimming" of profitable customers by competitors. Under the current conditions of the USO, Royal Mail has to offer its bulk mail services, Mailsort 1400 and Cleanmail products at uniform prices. Thus, as in most products included in the USO, the services with the highest margins will assist in subsidising the services which make a loss. On the other hand, competitors such as UK Mail and TNT can treat potential customers on an individual basis, and alter their prices depending on the costs imposed by that particular contract. This enables them to undercut the Royal Mail's prices and still make a healthy profit on the service. With the introduction of competition, those customers who feel they are paying too much for their bulk mailings can negotiate a cheaper deal with Royal Mail's competitors. This will result in the USO making a loss, as profitable customers choose to send their mail through another company, and as such the Royal Mail is unable to subsidise the loss making contracts. This could lead to what Crew and Kleindorfer (2005) refer to as a "Graveyard Spiral", which occurs when competitors are able to capitalise on cost-pricing misalignments caused by the fixed, universal pricing regime implemented under the USO. If this misalignment is large, i.e. the costs of provision are considerably below the price charged for the service, leading this contract to be susceptible to undercutting from competitors. However, the contract would have been used to finance loss-making services provided under the USO. This would cause unit prices for Royal Mail to rise, which would lead to a price rise, which, in all probability, would exacerbate the problem, and create a cyclical chain of events. Royal Mail's half-year accounts for 2009/10 show that one of every three items delivered by the company is through Downstream Access. Other estimates put the figure at 40% (Hooper et al 2008).

Precedents of Postal Competition:

It is useful to look upon precedents of markets which have been liberalised in the postal industry. The UK, is however the first country in Europe to induce competition to the market under the EU directive for 2008. The UK introduced competition to its postal market three years ahead of the schedule of the time. However, Sweden and New Zealand both liberalised their postal industries in the 1990s. Postcomm (2002) conducted an investigation into the effects that liberalisation has had on postal industries which have already had competition introduced, including Sweden and New Zealand.

Sweden:

The postal industry in Sweden was fully liberalised in 1993. Prior to the introduction of competition, the incumbent operator Sweden Post had a stable efficiency rate of around 80,000 letters per employee. However, between 1993 and 1999, the letters per employee rate increased dramatically, to around 135,000. Nevertheless, this is only one measure of efficiency. There was also a reduction in the real operating cost per letter, beginning in 1992, from 1.95SEK, to 1.53SEK in 1995, where the figure stabilised. This represents an annual growth in productivity of almost 9%. In spite of the increases in productivity, Sweden Post has seen revenue per letter and profit per letter fall in the years following 1993. Despite this, the company has remained profitable. This suggests that the majority of gains made in efficiency were passed onto the consumer in the guise of lower prices (Postcomm 2002). Sweden Post also posted increases in the quality of service it provided in the period following liberalisation. Next day delivery increased from 95.8% in 1992 to 97.3% 1998.

New Zealand:

Full liberalisation of the postal industry in New Zealand was completed in 1998, although it had been phased in over the previous decade. The incumbent operator, New Zealand Post, decreased its workforce by 43% in the ten years to March 1997 (Postcomm 2002). This helped towards an increase in letters per employee of between 70% and 112% over the same period, as estimated in Postcomm (2002). The quality of service provided by New Zealand Post improved from 94% in 1997/98 to 95.7% in 2001.

From the case studies from New Zealand and Sweden, it appears that in preparation for the liberalisation of the market, the incumbent operator begins to improve their productivity and efficiency. This effect has been mirrored in the UK, where Royal Mail has shed 60,000 jobs since the plans to fully liberalise the market were announced in 2002, whilst there has been a general trend of increases in the quality of service provided (Royal Mail Financial Accounts 2009). The change in market structure ensures that the incumbent has to change from a monopoly service provider to a competitive business. These improvements in efficiency are emulative of those seen in the former state monopolies in Britain post-liberalisation.

Boekler (2007) provides evidence for the formation of the industry. After ten years of a liberalised market in Sweden in 2003, the incumbent still had a market share of 92.9%, despite having over thirty competitors. This figure is the lowest of all incumbents in European liberalised postal markets. Andersson and ThArnqvist (2007) commented that the monopoly in the Swedish postal market was too powerful to be seriously threatened by new competitors. It is also suggested that the change of the incumbent's behaviour to that of a privately-owned, competitive company only served to strengthen its position in the market and prevent effective competition from developing. This provides support for Economides (2004) in suggesting that the market structure has not changed significantly since competition was introduced. In the UK, Europe Economics (2008) foresaw two possible scenarios developing in the postal market: one where competition continues primarily through access and one where end-to-end competition develops. The high end estimate of the study was that entrants could attain a combined market share of 8% by 2016. This would leave Royal Mail with a dominant 92% of the market, serving to highlight the aforementioned inequalities in the market structure, even where competition is plentiful. Contrary to the findings of Postcomm (2002), Boekler (2007) states that liberalisation has led to higher prices and a lower availability of postal services in almost all European markets. The paper suggests that there have been very few advantages for the consumer, and complicated regulations have been imposed. The report also mentions that the privatisation of the former monopolist in Germany has had a negative effect upon consumers. This is contradictory to the effects which privatisation and liberalisation have had upon the prices and conditions in the network industries such as the telecommunications and gas industries, where prices fell for consumers in the UK.

Chapter 4 - Possible Future Reform of the Postal Industry:

Crew and Kleindorfer (2008) make clear that there is a challenge facing postal reform, in that whilst the benefits of competition should be exploited, it is necessary that the risks it poses to the vitality of the incumbent operator are minimised. For this to be allowed to occur, it is important to firstly recognise where the reform of the industry may come from. It is necessary to establish and define where the market is today. There is debate as to whether there is a natural monopoly in some segments and indeed the entire industry. Evidence points to some criteria of natural monopoly being met, whilst others post inconclusive results. On the other hand, the International Post Corporation (2007) does not believe that there is a natural monopoly within the postal industry. However, most importantly, the stakeholders of the industry, as surveyed in Hooper et al (2008) believe that the delivery aspect of Royal Mail's business represented a natural monopoly due to the large costs that would be involved in creating a network to run parallel to the current one. If the competitors believe that there is a natural monopoly, then they are unlikely to invest in an end-to-end network. It is this belief that provides the barrier to entry, rather than any econometric data or evidence. Thus, it is unlikely that there will be much, if any, end-to-end competition in the postal industry in the near future. It is therefore evident that any reforms will be improvements of the current regulatory and competitive conditions rather than any radical new changes to the market.

• Changes in Regulatory Regime:

It has become clear that there are a number of issues blocking the progress of the regulation of the postal industry in the UK. The regulator's lack of power and subsequent inability to enforce competition laws within the postal industry places restrictions on the market as a whole. The limitation of only being able to apply ex ante regulation can be of detriment to the industry. One criticism of ex ante regulation is that it prevents all conduct of a certain type, even if that conduct is not detrimental to competition. Thus, ex ante regulation could potentially prevent behaviour or innovation which is beneficial to the consumer. On the other hand, ex post regulation is designed to only prevent behaviour which is of harm to the social good, ensuring that innovation is not averted as a rule. The introduction of ex post regulation to the industry could only be implemented once the regulator is certain that Royal Mail can be trusted not to employ anti-competitive behaviour to the expense of its competitors and consumers. As recommended by Hooper et al (2008), it would be beneficial for the Postcomm to have the power to enforce competition laws, enabling the establishment of a combination of ex ante and ex post regulation. However, as noted in Crew and Kleindorfer (2008), one of the aims of postal reform in Europe is to create an integrated communications industry. If this is to be realised, then the postal industry, when ready could be brought under the control of Ofcom, the communications industry regulator in the UK. As stated by Hooper et al (2008), Ofcom already has powers to impose ex post regulation, and has more manpower and resources at its disposal than the current regulator Postcomm. Hooper et al. recommend a change in the regulatory regime, and, in time this may be the preferable option for the future regulation of the industry. The IPC (2007) reinforces this view, suggesting that over time ex post regulation, or competition laws will be ideal for regulating the postal industry, and that artificial limitations on the industry are harmful to efficiency. This signals a move away from industry-specific regulation, which is one step further than grouping the postal industry with the other communications industries under Ofcom's control. Perhaps this is the ultimate endgame, but this should occur in stages to allow a smoother, more gradual transition.

• Changes to Downstream Access:

Royal Mail's accounts show that it makes a loss on the DSA items that it delivers on behalf of its competitors. Thus, the price it receives for access to the market does not cover its costs of delivering these items, as it should. There is a consensus amongst industry stakeholders that Royal Mail at least has to break even on the DSA agreement (Hooper et al 2008). Thus, it is recommended that the cost to competitors is raised to prevent any future losses for the incumbent on the access regime.

• Reforms to the Universal Service Obligation:

There are several possible reforms that could be made to the USO in the postal industry. It has been suggested that the obligation of the incumbent to supply the entire market every working day be shifted to a shared responsibility amongst all competitors. It has been suggested that the competitors would pay into a fund that would compensate Royal Mail for the losses incurred in the provision of the universal service, as is due to happen in France and the Netherlands when their markets are opened to competition. There is also the option for the state to incur any losses incurred by the USO, as will happen in Belgium upon liberalisation (Free Fair Post, 2009). However, Hooper et al (2008) declares that any compensation would be detrimental to the incumbent's efforts to improve its efficiency, and there is a danger of implementing too many changes at the one time. If when Royal Mail completes its modernisation program and reduces its costs per unit, the USO still makes a loss for the company, then the idea of compensating the business could be a more viable option. However, until Royal Mail's post-modernisation costs are established, this would be an unnecessary measure.

As the bulk mail market continues to become more competitive over time, it has been suggested that by reducing the ex ante regulations imposed on Royal Mail, competition can become fairer and prevent cream skimming from occurring. As over 40% of all bulk mail volume is now handled by competitors to Royal Mail (Hooper et al 2008), there is the potential for the removal of the Walksort 1400 and Cleanmail bulk mail products from the USO. This would mean Royal Mail would be able to negotiate contracts on an individual basis in the way that their competitors do, allowing the company to compete more ably with other operators on price for high volume mail contracts. The result would be the removal of one aspect of asymmetric competition that exists in the market, and preventing the occurrence of a graveyard spiral through cream skimming, which could threaten the preservation of the USO.

The other main aspect of asymmetric competition is the VAT exemption bestowed on Royal Mail, and all other state owned postal operators by the European Union. There have been complaints regarding the issue from competitors such as TNT. However, in April 2009, the European Court decided to that Royal Mail should retain its VAT exemption, due to the fact that the company retains sole responsibility for the USO in the UK (Reuters 2009) essentially, it is the universal service that is to remain exempt from VAT, rather than the company itself. This decision came against the wish of the industry regulator Postcomm. It appears that the VAT exemption will act as Royal Mail's 'compensation' for its responsibility for the USO.

• Privatisation:

Hooper et al (2008) recommend that the only way in which Royal Mail can survive is through a partnership with a private sector company. Effectively this would involve part-privatisation of the business. Evidence from the telecommunications industry suggests that the opening of the industry to competition in 1990 had a greater beneficial effect on the incumbent operator's operations and costs than privatisation of the company had six years prior. On the other hand, when the electrical companies were transferred from state to public ownership, there was a substantial improvement in their efficiencies, which led to cost improvements for the consumer. In the UK, everyday consumers face prices for stamps which are amongst the lowest in Europe (Boekler 2007), and low profit margins, which have thus far prevented full competition. It would remain to be seen if privatisation of Royal Mail would provide cost advantages for non-bulk mailers. Therefore there are mixed results in the case of privatisation of state monopolies. With the competitive postal market still in its infancy, and the regulatory controls still requiring much improvement, the decision on privatisation should be postponed until conditions are more stable and less likely prone to change. If the Royal Mail were to be privatised, it would be unclear as to which measure was most effective, the privatisation or implementation of the competitive market. Also, eliminating the market deficiencies such as asymmetric competition will improve Royal Mail's ability to compete for contracts with other operators. If, once these market deficiencies are eradicated, Royal Mail is still struggling, then the case for privatisation can be reopened, but these measures have to be given the chance to work. In this respect, this paper is in disagreement with Hooper et al (2008) that privatising Royal Mail is the only chance of survival for the business.

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